Q&A: China Will Not Demand Its Money Back

A deal is taking shape between Congress and the administration on the debt-ceiling vote, and it will likely include some spending cuts in exchange for increasing the amount the government can borrow.

As these negotiations play out, we're constantly warned that the debt-ceiling fight has high stakes. Refusing to raise the ceiling will prevent us from paying debts and will destroy the faith our bondholders -- that is, China -- have in us. Or will it? The Prospect talked with James K. Galbraith, the Lloyd M. Bentsen Jr. chair in government/business relations at the University of Texas at Austin, about just how accurate the doomsday predictions really are.

Everyone says that if we don't raise the debt ceiling soon, we'll have a financial disaster on our hands. How accurate are these catastrophic predictions?

Failure to raise the debt limit would be, for sure, a bad idea. Whether it would produce a fiscal and bond market Armageddon, I think, is really doubtful.

This is a group of politicians saying, give me cuts or I will shoot the economy. So that's the political problem that we face. And one way I think to handle that problem is to point out that what the hostage-takers have in their hands may well not be a nuclear grenade; it might be something much less cataclysmic.

A few weeks ago, the ratings agency Standard & Poor's warned that the United States could lose its AAA rating on U.S. debt (securities, bonds, etc.), which could have serious repercussions for the economy. How do you gauge the chances of a downgrade?

One can't judge what Standard & Poor's or Moody's will do, because they've gotten most everything else wrong in the last decade. These are firms that graded vast mounds of worthless mortgage-backed paper as AAA because of the crafty ways it was securitized. These are firms that never to my knowledge downgraded a major corporate fraud -- Enron and so forth -- more than a few days in advance of its collapse. And they routinely give cities lower ratings than they should based upon the default rates on those instruments. They have no particular competence in Europe, either. So, it's a little bit unpredictable what a corporation with that track record is going to do.

Is there a danger we'll default?

If you read the 14th Amendment, Section 4, it says that the [validity of the] debt of the United States authorized by law -- including pensions, by the way, so including Social Security -- shall not be questioned. So long as we are run by the Constitution, we're going to pay the debt.

One fear is that not raising the ceiling will cause a global panic or at least a ripple effect if the U.S. fails to pay its foreign creditors. What will foreign creditors do if we default on our bonds?

Let's suppose that the Treasury actually says to the People's Bank of China, sorry, we can't write a check to you right now. Well, in the case of the People's Bank of China, the bond that they hold would become a defaulted bond, but it would still be there. And the Treasury would still recognize its obligation on that bond and would presumably be willing to pay accrued interest on it. The Treasury would probably say, it's going to be a few days while we resolve this, and the People's Bank of China would, in my view, probably do nothing.

If I were sitting in the position of a foreign holder of U.S. Treasury securities in that situation, the last thing I would want would be a panic. I would want this problem to go away.

And if there is a panic?

I think the right analogy to that would be the failure of Congress to pass the [Troubled Asset Relief Program] on the first round. The stock market went down by 800 points. That sent a very powerful political wake-up call, and suddenly people changed their positions. The most likely thing if we actually go to this stage where there is real turmoil would be that Congress -- the hostage-takers -- would drop their guns.

So the question I would have then is: Does it make sense to give the hostage-takers what they want? Which are massive cuts. And I think it does not make sense by any stretch of the imagination to agree that the debt ceiling shall be the point of leverage for coming to a decision, which is what the Republicans want and unfortunately what some Democrats like Kent Conrad want.

This would be an act of just gross negotiating folly to set the precedent that the debt-ceiling negotiations become the way in which the extremists get what they want.